Two weeks ago, Detroit filed for bankruptcy protections, saying it is unable to pay back the roughly $18 billion it owes. The bankruptcy faces legal challenges from creditors who say emergency manager Kevyn Orr did not negotiate with them in good faith, and intended to steer the city into bankruptcy court. Emails from the winter involving Orr and state officials seem to support that claim. But if Orr can beat the legal hurdles and have the bankruptcy filing approved by a judge, the city will no longer need the approval of its creditors to repay less than what they are owed.
And then what happens? Here’s everything you need to know about who is owed what and how they might fair if the bankruptcy goes forward:
Who does Detroit owe? Detroit owes money to two broad categories of creditors: secured and unsecured creditors. The first, “secured” creditors, are those whose debt is backed by some kind of legal claim to a physical asset of the city. Detroit’s bond obligations relating to the water and sewer department (DWSD) is the largest example of “secured debt” on the city’s books, with over $5 billion in accumulated borrowing since the early 1990s. The water and sewer bonds are backed by the revenues that the city’s utility company brings in using the pipes built with the borrowed funds. Secured creditors generally get much better deals from bankruptcy proceedings than the organizations that don’t have liens on physical assets connected to the debt. The investment management firm BlackRock says the secured debts will be repaid in full. Indeed, Detroit is continuing to pay its secured debts during bankruptcy.
“Unsecured” creditors, on the other hand, face steep cuts. Detroit’s unsecured creditors include, but are not limited to, the current and former employees of the city – or more precisely, the pension funds that are supposed to pay those workers and their families in retirement. Detroit’s pension obligations are split into two funds, one for police and firefighters and the other for all other city employees. $5.7 billion in health and life insurance benefits for retirees are separate from the pension liabilities and are also unsecured.
The remainder of Detroit’s unsecured debt is owed to investors who bought the city’s debt over the years. Hedge funds have reportedly been buying up large amounts of these unsecured bonds. The bondholders, and the bond insurers who would have to pay out any difference between what Detroit pays and what the bondholders are owed, will have significant incentive to fight any effort to cut their payout. To minimize their own cuts, investors must push to maximize the cuts to pensions and retiree healthcare.
The Detroit Free Press published a list of the 20 largest unsecured creditors in the city’s bankruptcy filing, with the two pension funds in the top two slots – but the numbers from the filing are not necessarily correct.
How far behind is Detroit on funding its pension obligations? Detroit’s pensions are not particularly generous compared with other large cities, and the shortfall owes to a combination of demographics, bad management, and financial industry manipulation rather than extravagant promises to workers. The financial crisis also wiped out nearly a billion dollars in pension fund holdings.
But the size of the pension shortfall is in dispute. Before Kevyn Orr was appointed emergency manager, the pensions were well funded. The police and firefighter fund had assets worth 99.9 percent of its liabilities in 2011, and the general retirement fund was 82.8 percent funded. As recently as February, the city was $650 million short on the two accounts. But when Orr commissioned private actuaries to examine the city’s books, that unfunded pension debt jumped to $3.5 billion. Reuters municipal bond market expert Cate Long calls Orr’s calculations “pension voodoo.” Orr used non-traditional actuarial assumptions for his figures, which are supported by some in the profession. But the city’s previous estimates used revenue assumptions of about 8 percent annually, which is in line with the past 25 years of pension fund history and supported by the majority of actuaries.
Yet the actuarial differences alone can’t account for Orr’s figures showing a pension gap five times larger than traditional math shows, according to the Economic Policy Institute’s Monique Morrissey. Morrissey notes it’s impossible to check Orr’s math because the accounting firm he hired hasn’t published the “very rough preliminary guesstimates” used to write the emergency manager’s proposal.
What will determine the fate of the pensions? The actuarial dispute determines the size of the debt to retirees that will be factored into bankruptcy negotiations, but the future of Detroit retiree benefits is largely up to federal bankruptcy judge Steven Rhodes. Rhodes is still determining whether or not the city’s bankruptcy declaration is even valid, but if Orr’s case clears that hurdle the negotiations that follow over who gets paid when will be subject to Rhodes’ approval. As Ian Millhiser detailed last month, there are various legal obstacles to cutting pensions, including the Michigan Constitution’s specific pension protections. The state’s Republican Attorney General has pledged to defend retirees against cuts.
What is Detroit’s emergency manager proposing for pensioners and bondholders? The only clear blueprint so far for what Orr might seek in bankruptcy comes from a June pre-bankruptcy proposal. At the time, critics said the offer appeared designed to fail. When the city’s creditors rejected the deal, that shored up Orr’s case that he had tried to resolve the city’s finances but had no choice but bankruptcy. So there’s reason to think that the June proposal makes a poor guide to what any final resolution might look like. Retirees and bondholders alike had better hope so: The proposal would replace $11.5 billion in total unsecured debts with $2 billion split among the various creditors. For retirees, the plan includes unspecified “modification of benefits” for healthcare and “significant cuts in accrued, vested pension amounts” for all 30,000 active and retired participants in the system. Even taking Orr’s assertions about pension shortfalls at face value, and assuming “significant cuts” means over 50 percent, pension debts would still eat up more than half of that $2 billion proposal. That would leave little for bondholders – and gives investors and bond insurance companies a lot of reason to fight the bankruptcy.